Preparer Due Diligence Requirements

Tax preparers face significant responsibilities beyond simply completing tax returns. The IRS requires paid preparers to exercise due diligence when claiming certain tax benefits on behalf of their clients. Understanding these requirements is essential for the EA exam and everyday tax practice.

What Is Due Diligence?

Due diligence means the preparer must make reasonable inquiries to determine if a taxpayer is eligible for certain tax benefits and must properly compute the amounts claimed. This goes beyond accepting a client's word at face value. The preparer must ask questions, verify information, and document the process.

Due diligence requirements apply under IRC Section 6695(g) and are documented on Form 8867, Paid Preparer's Due Diligence Checklist.

Which Tax Benefits Require Due Diligence?

Form 8867 due diligence applies to four specific tax benefits:

Key Point: These are the only benefits covered by Form 8867 due diligence. Other credits and deductions have their own verification requirements but do not trigger Form 8867 penalties.

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The Four Due Diligence Requirements (KDCR)

The regulations under Treas. Reg. Section 1.6695-2 describe four requirements preparers must meet. An easy way to remember them is the acronym KDCR:

1. Knowledge Requirement

The preparer must know the tax law and apply that knowledge to the client's specific facts. This means:

• Understanding eligibility rules for each credit
• Asking appropriate questions to determine eligibility
• Not ignoring the implications of information received
• Making reasonable inquiries if information seems incorrect, inconsistent, or incomplete

Example: If a client claims three qualifying children for EITC but only provides documentation for two children's Social Security numbers, the preparer cannot ignore this inconsistency. They must ask about the third child and obtain proper documentation.

The preparer may not rely on client statements alone if a reasonable preparer would question the information based on what they know.

2. Document Requirement

The preparer must document the eligibility determination by completing Form 8867 for each return claiming the covered benefits. This includes:

• Completing all applicable sections of Form 8867
• Recording specific questions asked and the taxpayer's responses
• Maintaining notes about the interview process
• Documenting how eligibility was determined

The form must be completed based on information provided by the taxpayer or information the preparer reasonably obtains or knows.

3. Compute Requirement

The preparer must properly calculate the credit or verify the HOH filing status. This means:

• Using IRS-provided worksheets or software that performs the calculations
• Verifying that income, dependents, and other factors produce the claimed credit amount
• Ensuring the taxpayer meets all dollar thresholds and phase-out limits
• Confirming the computed amount matches what appears on the return

4. Retain Records Requirement

The preparer must retain five categories of records for 3 years from the latest applicable date:

Retention Period: Records must be kept for 3 years from the latest of:

• The return due date (without extensions)
• The date the return was e-filed
• The date the return was presented to the taxpayer for signature
• The date the return was submitted to the signing preparer (for nonsigning preparers)

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Due Diligence Penalties Under IRC 6695(g)

Failure to meet due diligence requirements triggers penalties under IRC Section 6695(g):

How Penalties Accumulate: If a return claims multiple covered benefits and the preparer fails due diligence on each one, separate penalties apply for each failure.

Example: A preparer fails to meet due diligence for EITC, CTC, and HOH on the same 2024 return. The penalty is:

• $600 (EITC) + $600 (CTC) + $600 (HOH) = $1,800 total penalty

Important: These penalties are assessed against the preparer, not the taxpayer. They apply even if the taxpayer was actually eligible for the credits. The penalty is for failing to document due diligence, not for incorrectly claiming credits.

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Other Preparer Penalties: IRC 6694 and 6695

Beyond due diligence, preparers face additional penalties for various violations. Understanding the complete penalty landscape is essential for the EA exam.

IRC 6694 - Understatement of Taxpayer Liability

IRC 6694 imposes penalties when a preparer's position on a return causes an understatement of the taxpayer's liability.

Key Distinctions:

• 6694(a) applies to negligent or unreasonable positions the preparer should have known about
• 6694(b) applies to intentional misconduct or deliberate disregard of regulations
• The 6694(b) penalty is reduced by any 6694(a) penalty paid on the same return

Reasonable Cause Defense: A preparer may avoid the 6694(a) penalty if they had reasonable cause for the position and acted in good faith. Factors considered include the nature and frequency of errors, normal office practices, and reliance on another preparer's advice.

IRC 6695 - Other Assessable Penalties

IRC 6695 covers various administrative and procedural failures. For 2024 returns:

Exam Focus: The EA exam frequently tests the distinction between the 6694 penalties (for incorrect positions) and the 6695 penalties (for procedural failures).

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Record Retention Requirements

Tax preparers have multiple record retention obligations:

General Retention (IRC 6107)

Under IRC 6107(b), preparers must retain either:

• A copy of each return they prepare, OR
• A list containing the name and TIN of each taxpayer for whom they prepared a return

Retention Period: 3 years after the close of the return period (July 1 through June 30 of the following year)

Penalty for Non-Compliance: $60 per failure under IRC 6695(d), maximum $30,000 per return period

Due Diligence Retention (Reg. 1.6695-2)

For Form 8867 due diligence records specifically, the 3-year period begins from the latest of the dates described above (due date, e-file date, signature date, or submission date).

Best Practice: Retain all supporting documentation for at least 3 years, including:

• Copies of taxpayer-provided documents (W-2s, 1099s, etc.)
• Notes from client interviews
• Completed Form 8867
• Worksheets and computations
• Any correspondence about eligibility questions

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Consequences Beyond Penalties

Failing to meet due diligence requirements can result in consequences beyond the monetary penalties:

1. Referral to Office of Professional Responsibility (OPR) - May result in suspension or disbarment from practice before the IRS
2. Referral to IRS Criminal Investigation - If failure is willful, criminal prosecution is possible
3. Injunction - The Department of Justice may seek to permanently bar the preparer from preparing tax returns
4. Employer liability - Firms employing non-compliant preparers can also be penalized

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Practical Due Diligence Checklist

When preparing returns with covered credits, follow this process:

1. Interview the client - Ask detailed questions about eligibility
2. Document responses - Record answers contemporaneously
3. Verify information - Do not ignore red flags or inconsistencies
4. Complete Form 8867 - Answer all questions based on actual knowledge
5. Perform calculations - Use worksheets or software to compute amounts
6. Retain records - Keep copies for at least 3 years
7. Submit the form - Include Form 8867 with the return (electronic or paper)

Exam Tip: The EA exam tests whether you understand that due diligence is about the process of determining eligibility, not just the outcome. A preparer who claims a legitimate credit but fails to document the determination can still face penalties.